effects of changes in government spending

6.2 Economic Issues – Government Control over the Economy: Changes in Government Spending

1. Government Economic Objectives and Their Relevance to Business

The government uses fiscal policy (spending and taxation) to try to achieve five macro‑economic objectives. For each objective, note why it matters to firms:

• Economic growth – higher national income expands markets for a firm’s products.
• Full employment – a tight labour market can push up wages and reduce the pool of available workers.
• Price stability – low, predictable inflation helps firms plan investment and set long‑term contracts.
• Balance‑of‑payments stability – a large current‑account deficit may lead to a weaker currency, affecting import costs and export competitiveness.
• Equitable distribution of income – reduced inequality can broaden consumer demand, especially for low‑priced goods.

2. What Is Government Spending?

Public expenditure can be split into two broad categories:

3. Automatic Stabilisers

These are parts of government spending that change automatically with the business cycle, without a new policy decision:

• Unemployment benefit payments rise when unemployment rises and fall when the labour market improves.
• Tax‑credit schemes that increase with household earnings.

Automatic stabilisers help smooth aggregate demand (AD) and reduce the size of recessions.

4. Reasons for Changes in Government Spending

• Economic recession – boost AD to protect jobs and output.
• Political priorities – new government may favour health, defence, climate action, etc.
• Fiscal targets – aim to reduce a deficit or build a surplus.
• External shocks – natural disasters, pandemics, wars that require emergency funding.
• Automatic stabilisers – increase or decrease automatically as the economy expands or contracts.

5. Direct Effects on the Economy

The immediate impact is on the sector that receives the money. These effects feed straight into the “G” component of aggregate demand.

6. Indirect (Secondary) Effects

• Higher consumer confidence → rise in private consumption (C).
• Increased demand for raw materials and services from firms supplying government projects → boost in private investment (I).
• Higher incomes raise tax receipts, partially offsetting the initial outlay.
• Potential crowding‑out if borrowing pushes interest rates up (see section 8).

7. How Businesses May Respond – Evaluation

8. Interaction with Tax Policy

Changes in spending are rarely financed in isolation. The government can:

• Raise taxes – reduces household disposable income (C) and after‑tax profit (affecting I).
• Borrow – may lead to higher interest rates (see below).
• Use existing surpluses – neutral impact on the private sector.

When evaluating a fiscal move, students should consider the combined effect of the spending change **and** the financing method on the five economic objectives.

9. Interest Rates and Crowding‑Out (Conceptual Diagram)

Higher government borrowing increases demand for loanable funds, which tends to push the market interest rate up. The direction of change can be shown as:

• Government borrowing ↑ → Supply of loanable funds unchanged → Interest rate ↑
• Interest rate ↑ → Cost of private borrowing ↑ → Private investment (I) ↓

This “crowding‑out” effect reduces the net boost to aggregate demand that the original spending increase intended.

10. The Multiplier Effect

Because each round of spending creates new income, the total rise in national income exceeds the initial outlay.

Simple multiplier formula:

$$k = \frac{1}{1 - MPC}$$

where MPC = marginal propensity to consume.

Example: if MPC = 0.8, then

$$k = \frac{1}{1 - 0.8} = 5$$

A £1 million increase in government spending could ultimately raise total output by £5 million, provided there is spare capacity and no significant crowding‑out.

Circular‑flow illustration (suggested diagram)

Show the flow: Government spending (G) → Income for households & firms → Consumption (C) → Further income → … Each arrow represents a round of spending, visually demonstrating the multiplier.

11. Potential Unintended Consequences

1. Inflationary pressure – when the economy operates near full capacity, extra demand pushes prices up.
2. Higher public debt – persistent deficits increase future borrowing costs and may require higher taxes later.
3. Crowding‑out of private investment – rising interest rates make private borrowing more expensive.
4. Resource misallocation – politically driven projects may not deliver the greatest economic return.

12. Case Study – UK Fiscal Stimulus 2022

In response to a post‑pandemic slowdown, the UK government announced a £30 billion increase in spending on infrastructure and public services.

• Direct effects – construction employment rose by 3 %; health staffing levels increased.
• Indirect effects – consumer confidence improved; retail sales grew by 2 % (C component of AD).
• Financing – largely funded by borrowing; interest rates were kept low (1.5 %) by the Bank of England, limiting crowding‑out.
• Unintended outcome – by 2024 inflation reached 6 %; the Bank raised rates to 4 %, which began to suppress private investment (I).
• Link to objectives – the stimulus aimed at economic growth and full employment, but the inflationary side‑effect threatened price stability.

13. Suggested Diagram for Revision

Diagram: Circular flow of income with an injection of government spending (G). Show the resulting rise in aggregate demand (AD) and the successive rounds of income‑spending that illustrate the multiplier effect.

14. Key Points to Remember

• Government spending directly influences the “G” component of AD; transfer payments mainly affect “C”.
• Automatic stabilisers adjust spending automatically with the business cycle.
• Businesses respond by changing output, prices, hiring and investment; each response has potential advantages and disadvantages.
• The size of the multiplier depends on the MPC and the amount of unused capacity.
• Financing the spending (taxes, borrowing) determines whether the policy will also affect consumption, investment or interest rates.
• Unintended consequences – inflation, higher debt, crowding‑out, and inefficient allocation – must be weighed against the intended macro‑economic objectives.